Category Archives: Concealment Strategies

Reaching Behind the Curtain

Not too long ago a close friend of one of our Chapter members paid a substantial sum of money to a relative, the owner of a closely held corporation, in exchange for a piece of the relative’s real estate to which, it turns out,  the relative/owner did not have clear title.  The relative apparently used a substantial portion of the funds to immediately clear debts of his corporation of which he and his wife are the sole officers and shareholders.  He now claims that, since he used the sale proceeds for corporate purposes, the refund of the purchase price he owes our Chapter member’s friend is a debt of the corporation and not of his personally.   Our Chapter’s friend has engaged an attorney at the suggestion of our certified Chapter member.

Our legal system recognizes that corporations have a separate existence from their shareholders/owners and are treated as ‘individuals’ under the law. There are two ways for a wrong-doer to use the existence of a corporation to avoid efforts to recover a money damage judgment from him or her:

–As in this case, the scammer argues that the corporation and not the shareholder/owner committed the offense, and therefore the shareholder’s personal assets and property should not be used to satisfy any judgment for the offense.

–Argues that the wrongdoer/shareholder’s property is held in the name of the corporation, and therefore s/he has no personal assets that can be used to satisfy a judgment against him  or her.

The first reflects the classic doctrine that shareholder/owners are not liable for the debts or liabilities of the corporation. Of course, if the shareholder/owner also controls the corporation and personally acted wrongfully, s/he may still be liable for her misconduct, and the corporation may simply be jointly and severally liable together with her. Whether the wrongful conduct was that of the corporation or that of an individual shareholder usually is a question of fact to be decided by the jury.

The second reflects the corporation’s ability, as a separate legal entity, to own its own property. If the corporation owns the property, then the individual shareholder does not.  Since both pre-judgement attachment writs and writs of execution can only reach a defendant’s interest in leviable assets, a wrongdoer can appear without assets and judgment proof – and your client can be unable to satisfy a money judgment against her- if the wrongdoer/shareholder has transferred title in her personal assets to the corporation. This does not apply to a non-money judgment to recover specific money or property which can reach proceeds or property in the hands of the wrongdoer or of third persons. Of course, if the wrongdoer’s transfer of assets to the corporation was to defraud creditors, the injured party can seek to have the transfers set aside.

However, even where a corporation apparently shields the defendant or his or her property, the wrongdoer and her leviable property can still be reached if the court can be convinced to disregard the corporation or to regard it merely as her alter ego. The court may do so if it can be proved that the corporation is merely a sham whose sole purpose is to help the wrongdoer fraudulently avoid liability for her conduct. This is sometimes called piercing the corporate veil.

If the corporation is found to be the alter ego of the shareholder, then either or both of the following consequences apply, depending on the goal in piercing the corporate veil:

–The wrongdoer is no longer shielded from liability for the corporation’s misconduct because the wrongdoer and the corporation are viewed by the court as one and the same.

–Corporate property can be reached to satisfy a judgment against the wrongdoer because the property is now regarded, properly, as the wrongdoer/shareholder’s property.

One of the factors to consider in attempting to pierce the corporate veil is whether the corporation is closely held; i.e. owned or directed by one or by a small or limited number of shareholders, officers, and directors (often all the members of the same family). Obviously, the larger the number of shareholders, and the more broadly the corporation’s directing positions are distributed, the less likely it is to be a sham or alter ego for one person. However, given the lawful goals and purposes of incorporation, even a small, closely held corporation may be legitimate. Conversely, the existence of other shareholders or other directors and officers may not mean that the corporation is not a sham.

The ACFE tells us that there is no hard and fast test to determine whether a corporation is a sham. Instead, courts will look at a variety of factors to determine whether to pierce the corporate veil. These factors include:

–As in this case, does the wrongdoer exercise sole or ultimate control over the activities of the corporation?

–Does the corporation’s charter describe the approved activities of the corporation with some specificity, or is it left largely to the discretion of the wrongdoer?

–Does the corporation fail to hold director’s and shareholder’s meetings, record minutes of those meetings, and otherwise observe the formalities of corporate existence?

–Is the corporation so undercapitalized as to raise questions about its viability as a separate entity?

–Are the corporation’s finances so intertwined or identifiable with those of the wrongdoer as to raise questions about its separate existence?

–Does the corporation own property which does not seem to reasonably relate to its activities, particularly as described in its charter?

–Does the wrongdoer use the corporation’s property as if they were her own, personal assets, including but not limited to whether she uses them for purposes not within the corporation’s approved activities?

These and similar or related facts can indicate that the corporation is a sham and has no true, separate existence from the wrongdoer/shareholder. In that case, the court would be justified in ruling that the corporation should be regarded as an alter ego of the wrongdoer and that the corporation and the wrongdoer be considered as one and the same ‘person’ for purposes of determining liability or levying on assets to satisfy a money judgment.

Many thanks to our member for bringing this case to our attention!

Concealment Strategies & Fraud Scenarios

I remember Joseph Wells mentioning at an ACFE conference years ago that identifying the specific asset concealment strategy selected by a fraudster was often key to the investigator’s subsequent understanding of the entire fraud scenario the fraudster had chosen to implement. What Joe meant was that a fraud scenario is the unique way the inherent fraud scheme has occurred (or can occur) at an examined entity; therefore, a fraud scenario describes how an inherent fraud risk will occur under specific circumstances. Upon identification, a specific fraud scenario, and its associated concealment strategy, become the basis for fraud risk assessment and for the examiner’s subsequent fraud examination program.

Fraud concealment involves the strategies used by the perpetrator of the fraud scenario to conceal the true intent of his or her transaction(s). Common concealment strategies include false documents, false representations, false approvals, avoiding or circumventing control levels, internal control evasion, blocking access to information, enhancing the effects of geographic distance between documents and controls, and the application of both real and perceived pressure. Wells also pointed out that an important aspect of fraud concealment pertains to the level of sophistication demonstrated by the perpetrator; the connection between concealment strategies and fraud scenarios is essential in any discussion of fraud risk structure.

As an example, consider a rights of return fraud scenario related to ordered merchandise. Most industries allow customers to return products for any number of reasons. Rights of return refers to circumstances, whether as a matter of contract or of existing practice, under which a product may be returned after its sale either in exchange for a cash refund, or for a credit applied to amounts owed or to be owed for other products, or in exchange for other products. GAAP allows companies to recognize revenue in certain cases, even though the customer may have a right of return. When customers are given a right of return, revenue may be recognized at the time of sale if the sales price is substantially fixed or determinable at the date of sale, the buyer has paid or is obligated to pay the seller, the obligation to pay is not contingent on resale of the product, the buyer’s obligation to the seller does not change in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale is economically separate from the seller, the seller does not have significant obligations for future performance or to bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.

Sales revenue not recognizable at the time of sale is recognized either once the return privilege has substantially expired or if the conditions have been subsequently met. Companies sometimes stray by establishing accounting policies or sales agreements that grant customers vague or liberal rights of returns, refunds, or exchanges; that fail to fix the sales price; or that make payment contingent upon resale of the product, receipt of funding from a lender, or some other future event. Payment terms that extend over a substantial portion of the period in which the customer is expected to use or market the purchased products may also create problems. These terms effectively create consignment arrangements, because, no economic risk has been transferred to the purchaser.

Frauds in connection with rights of return typically involve concealment of the existence of the right, either by contract or arising from accepted practice, and/or departure from GAAP specified conditions. Concealment usually takes one or more of the following forms:

• Use of side letters: created and maintained separate and apart from the sales contract, that provide the buyer with a right of return;

• Obligations by oral promise or some other form of understanding between seller and buyer that is honored as a customary practice but arranged covertly and hidden;

• Misrepresentations designed to mischaracterize the nature of arrangements, particularly in respect of:

–Consignment arrangements made to appear to be final sales;

–Concealment of contingencies, under which the buyer can return the products, including failure to resell the products, trial periods, and product performance conditions;

–Failure to disclose the existence, or extent, of stock rotation rights, price protection concessions, or annual returned-goods limitations;

–Arrangement of transactions, with straw counterparties, agents, related parties, or other special purpose entities in which the true nature of the arrangements is concealed or obscured, but, ultimately, the counterparty does not actually have any significant economic risk in the “sale”.

Sometimes the purchaser is complicit in the act of concealment, for example, by negotiating a side letter, and this makes detection of the fraud even more difficult. Further, such frauds often involve collusion among several individuals within an organization, such as salespersons, their supervisors, and possibly both marketing and financial managers.

It’s easy to see that once a CFE has identified one or more of these concealment strategies as operative in a given entity, the process of developing a descriptive fraud scenario, completing a related risk assessment and constructing a fraud examination program will be a relatively straight forward process. As a working example, of a senario and related concealment strategies …

Over two decades ago the SEC charged a major computer equipment manufacturer with overstating revenue in the amount of $500,000 on transactions for which products had been shipped, but for which, at the time of shipment, the company had no reasonable expectation that the customer would accept and pay for the products. The company eventually accepted back most of the product as sales returns during the following quarter.

The SEC noted that the manufacturer’s written distribution agreements generally allowed the distributor wide latitude to return product to the company for credit whenever the product was, in the distributor’s opinion, damaged, obsolete, or otherwise unable to be sold. According to the SEC, in preparing the manufacturer’s financial statements for the target year, company personnel submitted a proposed allowance for future product returns that was unreasonably low in light of the high level of returns the manufacturer had received in the first several months of the year.

The SEC determined that various officers and employees in the accounting and sales departments knew the exact amount of returns the company had received before the year end, when the company’s independent auditors finished their fieldwork on the annual audit. Had the manufacturer revised the allowance for sales returns to reflect the returns information, the SEC concluded it would have had to reduce the net revenue reported for the fiscal year. Instead, the SEC found that several of the manufacturer’s officers and employees devised schemes to prevent the auditors from discovering the true amount of the returns, including 1), keeping the auditors away from the area at the manufacturer’s headquarters where the returned goods were stored, and 2), accounting personnel altering records in the computer system to reduce the level of returns. After all the facts were assembled, the SEC took disciplinary action against several company executives.

As with side agreements, a broad base of inquiry into company practices may be one of the best assessment techniques the CFE has regarding possible concealment strategies supporting fraud scenarios involving returns and exchanges. In addition to inquiries of this kind, the ACFE recommends that CFE’s may consider using analytics like:

• Compare returns in the current period with prior periods and ask about unusual increases.

• Because companies may slow the return process to avoid reducing sales in the current period, determine whether returns are processed in timely fashion. The facts can also be double-checked by confirming with customers.

• Calculate the sales return percentage (sales returns divided by total sales) and ask about any unusual increase.

• Compare returns after a reporting period with both the return reserve and the monthly returns to determine if they appear reasonable.

• Determine whether sales commissions are paid at the time of sale or at the time of collection. Sales commissions paid at the time of sale provide incentives to inflate sales artificially to meet internal and external market pressures.

• Determine whether product returns are adjusted from sales commissions. Sales returns processed through the so-called house account may provide a hidden mechanism to inflate sales to phony customers, collect undue commissions, and return the product to the vendor without being penalized by having commissions adjusted for the returned goods.